Covered Calls vs. Protective Puts: A Risk-Reward Analysis

If you are a potential investor in India who wants to upgrade your investment portfolio, you have likely heard of covered calls and protective puts. Covered calls and protective puts are strategies intended to reduce risk and increase return, although they have different purposes and risk attributes. It is important to understand how each strategy works so you can choose the one that best fits your investment goals.

This article will explain covered calls and protective puts, describe how strategies work, and explain their differences. By the end of this article, you will better understand how to use covered calls and protective puts in alignment with your investment goals and how to trade them on Indian exchanges.

What Are Covered Calls?

A covered call is an options strategy in which you own a long position in a stock and sell a call option on that stock. This is often a way to generate income by selling the call option and collecting the premium. The stock you own is considered “covered” because you own the underlying asset (the stock) that can be sold if  the call option is exercised.

To explain the meaning of covered calls, let’s say you own shares of a stock and sell a call option with a strike price and expiration. In exchange, you receive a premium (the option’s price). This works best when you think the stock will stay flat or rise moderately.

Covered Calls Example

To illustrate this strategy, let’s use an example. Assume you own 100 shares of Reliance Industries, which is currently trading at ₹2,000 per share. You sell a call option for ₹50, with a strike price of ₹2,100 and an expiration date of one month. Thus, you receive ₹5,000 (₹50 x 100) for selling the option.

• If Reliance continues to trade below ₹2,100, you will keep the call option premium and your shares.
• If Reliance rises above ₹2,100, expiring in one month, you would be required to sell your shares at ₹2,100, the call option’s strike price, but you will keep the option premium.

This strategy provides federal income; however, it limits your profit potential. If Reliance rises significantly and is executed at a higher stock price above ₹2,100, you will still be forced to sell.

What is a Protective Put?

On the other hand, a protective put is a strategy to buy a put option to hedge an existing stock position. A protective put means you purchase the right to sell your stock at a predetermined price (strike price) over a specific period. The protective put strategy provides insurance against a significant decrease in stock price. If the stock price decreases below the strike price, the put will provide a profit, thus offsetting the loss on the stock position. If the price increases, the put option won’t be used, and you’ll only lose the premium you paid.

Protective Put Example

Let us consider another example to understand the rationale of this strategy better. Suppose you own 100 HDFC Bank shares trading at ₹1,400. If the stock falls meaningfully, you prefer downside protection, so you purchase a protective put option with a strike price of ₹1,350, which expires in one month. You pay a premium of ₹30 per share for the put option.

• If HDFC Bank’s price falls below ₹1,350, the put option gives you the right to sell your 100 shares at ₹1,350, thereby limiting your losses. To demonstrate, if the price of HDFC Bank goes down to ₹1,300, the put option allows you to sell at ₹1,350, which saves you ₹50 on every share you own.
• If HDFC Bank’s price rises above ₹1,400, you won’t use the put option. However, you lose the ₹3,000 premium (₹30 × 100), but you benefit from the rise in the stock price.

The protective put strategy ensures that your losses are capped, but it comes at the cost of the premium you pay for the option.

Difference between Protective Put and Covered Call

Conclusion

Covered calls and protective puts are effective techniques to identify risk and enhance returns. Covered calls are useful for creating income if you do not expect a stock to decline significantly and expect a moderate upside. At the same time, a protective put option would be good if you want to protect the stock from significant downside risk without losing upside potential. Learning about the strategies, advantages, and risks can help you make better decisions based on your market view. Whether to generate income, protect your investment, or just help you manage your portfolio better, a covered call and a protective put can help you manage the market’s ups and downs.

If you are looking to use these strategies in the Indian market, you might consider using Religare Broking’s options trading features.